Selling Put Options

How Does Selling Put Options Work in Options Trading?

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Selling Put Options - Introduction

So, you wish to make a predictable fixed profit through options trading over the course of a week or a month? On top of that, you wish to make that profit no matter if the underlying stock goes up, down or even sideways? And you wish to have a second chance at making a profit even if the trade goes bad?

What if I tell you ALL of these wishes can be fulfilled, LEGALLY, through the use of a single, simple options strategy called "Put Options Writing" or "Out of the money Put Options Writing" or "Naked Put Write" or simply "Selling Put Options"?

Yes, achieving all of these effects may sound completely illegal in basic investment knowledge but is perfectly legal and possible through the use of options. This is why Selling Put Options is one of the most popular options strategies in the world today alongside other popular options strategies such as the "Covered Call". Yes, if it is difficult to profit from buying options, selling put options puts you in the seat of the "Banker", selling options to options traders who wish to play the buying side of the game. So, how is it that selling put options can perform all these wonders? Are there no disadvantages? No options strategies are perfect. This options trading tutorial shall discuss the advantages and disadvantages of Selling Put Options, how it works and how to sell put options step by step.

Selling Put Options - Confusion with "Buying Put Options"

If you are a beginner in options trading, you might be one of those who mistake "Buying Put Options" for "Selling Put Options". Yes, ALOT, a MASSIVE LOT, of options beginners typically confuse "Buying Put Options", which is profiting from a DOWNWARDS price movement in the underlying stock by trading put options, which is a Bearish inclined options strategy, with "Selling Put Options", which is profiting as long as the price of the underlying stock remains ABOVE the strike price of the put options and is mainly a Bullish inclined options strategy. Yes, one mistake in the use of the terms "Buy" or "Sell" means using put options for COMPLETELY different purposes!

A lot of options beginners make this mistake because they tend to come from a background of trading stocks and in stock trading, the way to profit from a downwards move in the stock is to "Sell" or "Short" the stock. As such, in order to simpify their understanding of options, they tend to associate Call Options, with BUY as it profits primarily from an upwards move, and associate Put Options, with SELL as it profits primarily from a downwards move. As such, I always see options beginners say they are "Selling Put Options" when in fact they mean they wish to BUY put options in order to profit from a downwards price movement in the underlying stock! Consequently, many of them carry that mistake into the options order itself and used the "Sell To Open" order when they mean to BUY put options and end up with a short put options position that profits primarily from an upwards move in the underlying stock, which of course, is contrary to their intended trade. Worse of all, if the stock does move downwards strongly as they have predicted correctly, they could make huge unintended losses on their short put options position. As such, it is very important to first get this mistake out of the way before you read on... are you buying or selling put options?

If you are confused with these concepts, please head to my Options Trading for Dummies guide where I explain the above concept clearly with completely layman terms and examples.

What Exactly is Selling Put Options?

Put options are options contracts that gives the holder of the contract the rights to sell the underlying stock at a fixed price. As such, one would buy put options when one expects the price of the underlying stock to move downwards (for a completely layman explanation, please refer Options Trading for Dummies). Yes, you would buy the rights to SELL something at a fixed price only because you expect the price to fall, right?

Selling Put Options Example: Buying Put Options For instance, if XYZ stock is trading at $100 and you buy the right to SELL the stock at $100 by buying its put options. If the price of XYZ does fall to let's say $50 and you still have the rights to sell the stock at $100 through the put options, you would be able to make a $50 profit by buying at $50 and then selling at $100.

This is a very simplistic example of how put options profit from a drop in the price of the underlying stock. As such, options traders buy put options when they expect the price of the underlying stock to drop and therefore make a profit from it.

However, you can only profit through buying put options when the price of the underlying stock goes downwards. No profit can be made if the stock moves upwards even by a little or sideways. As such, it could be very difficult to profit from buying put options if you are not tip top in your ability to predict when the price of the underlying stock is going to go downwards (yes, long call and long put trading is extremely complex and requires extreme detailed analysis like our proprietary 9 steps process. Check it out at www.Optiontradingpedia.com Premium Picks Service). However, this dynamic turns around if instead of buying put options, you sell them instead and become "banker" to those who wishes to buy put options.

Yes, when you sell put options, also known as to write put options, you are creating a new put options contract through the broker and then selling it to another options trader who wants to buy put options. This puts you in the seat of the "banker", with the ability to pocket the "bet money" known as put options premium, that the buyer of your put options pays you in order to own the put options contract.

Selling Put Options Example: Selling Put Options For instance, if XYZ stock is trading at $100 and you decide to sell 1 contract of the $90 strike price put options that have a market price of $1.00 now. You sold 1 contract of the put option in the open market to another options trader at $1.00. The options trader pays you $1.00 x 100 (the price of 1 contract of options is multiplied by 100 because each contract covers 100 shares of the underlying stock) = $100. By expiration of the put options contract, XYZ stock remained at $100 and didn't go down beyond the strike price of $90. The buyer of your options contract lost the bet and you get to pocket the $100 premium as profit as the put options you sold expire worthless.

As you can see from the example above, in selling put options, you make a fixed profit by expiration of the put options ($100 in the example above), which could be in a week's time or a month's time or longer depending on which expiration date you sell the put options on, and you make that profit as long as the price of the underlying stock does not drop below the strike price of the put options. This means you profit when the price of the underlying stock goes upwards indefinitely, you profit when the price of the underlying remains sideways (like $100 in the example above) and you profit even if the price of the underlying stock goes downwards a little as long as is above the strike price of the put options ($90 in the example above)... in ALL 3 possible stock price directions whereas when you buy put options, you only win when the price of the underlying stock goes downwards, in only 1 out of 3 possible stock price directions. This is why the chances of winning in selling put options is mathematically higher than the chances of winning in buying put options.

Selling Put Options - Losing and Getting a Second Chance

As mentioned above, selling put options allows you to profit when the price of the underlying stock moves upwards indefinitely, sideways or slightly downwards. As such, it is a bullish inclined options strategy. As a bullish options strategy, there is only one way you, as the seller of the put options or the "banker", is when the buyer of the put option wins the "bet" when the stock price moves downwards strongly. Yes, when an options trader buys put options, that options trader is betting on the price of the stock going downwards strongly and if that happens, the buyer of the put options stand to make an unlimited profit as long as the price of the stock keep going downwards. Where does that "unlimited profit" come from? You, the seller of the put options or the "banker" of course.

Selling Put Options Example: Losing For instance, if XYZ stock is trading at $100 and you decide to sell 1 contract of the $90 strike price put options that have a market price of $1.00 now. You sold 1 contract of the put option in the open market to another options trader at $1.00. The options trader pays you $1.00 x 100 (the price of 1 contract of options is multiplied by 100 because each contract covers 100 shares of the underlying stock) = $100. By expiration of the put options contract, XYZ stock drops to $70, which is $20 below tthe strike price of $90. The buyer of your put options make a profit of $20 x 100 = $2000. This $2000 becomes a loss to you, the seller of the put options.

As you can see above, if the price of the underlying stock goes down strongly, as the seller of the put options, you stand to make a much bigger loss than the options premium you received for selling the put options. Yes, nothing is perfect in options trading and there are no perfect options strategies. All options strategies are about give and take, pros and cons. Even though selling put options gives you a mathematically high chance of winning by being able to win in all 3 possible stock price directions, that one single scenario in which it could make a loss is a potentially big loss. Doesn't that make selling put options very dangerous?

Well, the good news is that there are two main ways to mitigate this risk when you sell put options. First of all is simply setting a stop loss point so that when things go bad, you take a small, predetermined loss and get out of the trade. This is the most basic way. BUT, there is a better way. A way that gives you that second chance of profiting that was mentioned in the introduction section above. Yes, selling put options not only gives you a phenomenally high mathematical chance of making a fixed predetermined profit, it also gives you a second chance of getting back your losses when things go wrong! How is that possible?

Through allowing the put options to be assigned (exercised).

When put or call options expire In The Money like in the example above and you do not close the position and take the loss, the option becomes assigned (exercised). This means that the right of the option is automatically exercised. When you buy call options and it gets exercised, you buy the underlying stock at the strike price of the call options. When you sell call options and it gets assigned, you end up with a short position on the underlying stock like you shorted the stock. When you buy put options and it gets assigned, your stocks get sold if you own the stock and the puts or you end up with a short position on the underlying stock like you shorted the stock if you don't already own the stock. Finally, when you sell put options and it gets assigned, you end up buying the stock at the strike price of the put options!

Selling Put Options Example: Getting Assigned For instance, if XYZ stock is trading at $100 and you decide to sell 1 contract of the $90 strike price put options that have a market price of $1.00 now. You sold 1 contract of the put option in the open market to another options trader at $1.00. The options trader pays you $1.00 x 100 (the price of 1 contract of options is multiplied by 100 because each contract covers 100 shares of the underlying stock) = $100. By expiration of the put options contract, XYZ stock drops to $70, which is $20 below tthe strike price of $90. The buyer of your put options make a profit of $20 x 100 = $2000. This $2000 becomes a loss to you, the seller of the put options. Instead of closing the put options and allowing the buyer to pocket the profit, you allow the in the money put options to expire in the money and end up buying 100 shares of XYZ stock at $90 per share (strike price of the put options). So now, instead of taking a loss, you now own 100 shares of XYZ stock bought at $90 per share.

As you can see from the example above, instead of taking a loss by closing the position, you could instead let it be assigned for the underlying stock! By buying the underlying stock at the strike price of the put options sold, you now hold shares in the stock bought at a price higher than the prevailing market price, at a loss, but now, instead of holding an options position which eventually expires, you now hold the underlying stock instead that doesn't expire! This means you can hold it for as long as you wish for the day the stock turn back profitable! That's the second chance that I have mentioned above, a second chance to profit even though the trade was a losing one! Also, this assignment doesn't only happen during expiration. It could happen at any time if the put options that you sold gets In The Money. What if you don't have the cash to buy the underlying stock? Well, that could almost never happen due to one of the disadvantages of Selling Put Options...

Selling Put Options - Disadvantage: Margin

Yes, you could almost have no cash to buy the underlying stock due to one of the biggest disadvantage of Selling Put Options that dramatically reduces its return on investment... Margin. (read more about Options Margin.)

Margin means that in order to Sell Put Options, the broker needs to make sure you have the cash to fulfill your obligation of buying the underlying stock should the options be assigned. In order to do so, the broker would require that you have an amount of cash in your account that will be locked up for as long as the put options you own remains active. This amount of cash is typically the full cash needed to purchase the underlying stock in the event of an assignment. Lets take a look at a real life example in the picture below. AAPL was trading at $141.42 and its slightly out of the money put options expiring in one month's time, say the $139 strike price put options (anything higher would be too close to getting in the money on just a very slight downwards movement and would not take full advantage of profiting in all 3 directions) selling at $1.32. In order to sell this put option, you need to lock up something like $139 x 100 = $13,900 in cash. Locking up $13,900 to make $132, which is a return on investment (ROI) of only 0.95% in a month. Furthermore, if you don't even have that much cash in your account in the first place, you won't even be able to sell put options on AAPL at all (as you will see in the selling put options demonstration video further below). Furthermore, even if you have that cash, you may still not be able to sell put options at all! Why? Because as an options beginner, you may not even have that high an options account level in the first place... which brings us to the next disadvantage of selling put options...

Selling Put Options - Disadvantage: Account Level

In order to control risk, brokers assign an "Account Level" to all options trading accounts (read all about Options Account Trading Levels). Different levels allow the option trader to perform only certain kinds of options strategies according to the "riskiness" of each category of options strategy. Unfortunately, Selling Put Options or Naked Put Write, is assessed to be of very high risk and would typically require the highest level options trading account (level 5 in most cases like in optionsxpress.com) which usually take years of experience and / or a lot of cash in your options account to attain. Different options brokers have different requirement but in all, Selling Put Options isn't an options strategy beginners at options trading could perform even if you have the money to do so due to the low starting options account level. Yes, selling put options is an options strategy for high level options traders, quite literally.

Selling Put Options - Disadvantage: Unlimited Loss

A lot of people will tell you that selling put options or call options expose you to unlimited loss potential. While that is true for selling call options as losses accumulate for as long as the stock keep rising, having no limit, it is technically not true for selling put options as even though losses willl accumulate for as long as the stock keeps going downwards, there is a limit downwards... $0. Yes, that's all you can loss in selling put options, wwhich translates to the whole amount of cash that was tied up as cash margin, nothing more than that.

How To Sell Put Options - Step By Step

Step 1: Choose the stock that you wish to sell the put options on. Ideally, its a stock that has been going up and up like AAPL (just an example, not suggesting AAPL will never go down) in our example above.

Step 2: Scroll to the next month expiration. In our selling put options example above and in the video beloww, we are in March and will therefore sell the April put options.

Step 3: Choose the put option that is 2 to 3 strikes out of the money in order to profit even if the stock ends up slightly negative rather than positive. In our example, it will be the $139 strike price.

Step 4: Make sure you have enough cash in your account for margin requirement and use the Sell to Open order.

The video below demonstrates the selling put options example in this tutorial as well as what you will see if you don't have enough cash in your options account to meet the margin requirement.

Why Not Sell Call Options?

Why is selling put options so famous? Why not selling call options? Why isn't selling call options as popular as selling put options? Well, the reason really is that the market is more often than not in a bull trend rather than a bear trend. Selling call options means you profit primarily when the stock goes DOWNWARDS, which is typically a less common scenario than going upwards. Also, when a short call option gets assigned, you end up with an awkward short stock position, which is something that is hard to hold for the long term, unlike a long stock position. These reasons are why selling call options isn't as popular as selling put options. Furthermore, selling call options exposes you to true unlimited loss as losses will continue to accumulate for as long as the price of the underlying stock keep going upwards, and there is no limit to how high as stock can rise to.

What If You Can't Sell Put Options?

What if you are unable to sell options due to either a lack of cash in your options account or a lack of a high enough trading level, you could still profit from buying call and put options if you can buy them on very accurate picks! This is a great way to make a leveraged profit and you can buy call and put options with as little as a couple of hundred dollars rather than tens of thousands of dollars needed for selling put options. If you wish to follow such a highly accurate pick service for buying call and put options, please visit our www.Optiontradingpedia.com Premium Options Picks service!

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